High Free Cash Flow = Bad Investment?

Most of us at The Motley Fool, including me, love free cash flow. But if we take that obsession too far, we'll buy into companies we shouldn't, and miss out on some truly great stocks as well.

Today, I'll show you how to avoid that mistake -- and give you a list of stocks with negative free cash flow that might be poised for greatness.

Good FCF, bad FCF
We love free cash flow for a number of reasons, mainly because it gives us a more realistic view of a company's earning power. Yet as you've probably learned if you've been investing for more than a few days now, nothing is ever simple in the world of stock picking.

Joel Litman, the managing director at Equity Analysis & Strategy, is one of top experts around when it comes to evaluating cash flows. At a recent presentation at Fool HQ, he pointed out that there are times to buy heavily into a company with negative free cash flow. Determining "good negative free cash flow" and "bad negative free cash flow" begins with a look at a company's rate of return alongside its rate of growth.

Big orange
The perfect example is Home Depot. The home improvement retailer absolutely plastered (get it?) the market from 1985 to 2001, yet showed negative free cash flow in all but one of those 16 years.

Home Depot's negative free cash flow during this 16-year period was the result of management pouring all its cash back into its high-return business -- and not by any deficiency in the business itself. "As long as that growth in capital will realize returns above the cost of that capital," Litman says, "negative free cash flows can be a great sign for the business."

In 2001, Home Depot finally hammered out positive free cash flow, and has maintained that positivity every year since. And what has the stock price done in that period?

While some may question investors' sanity during this run, Litman points out that the market understood the issue very well, namely that the positive free cash flow was the result of management slowing its rate of reinvestment back into the business. This is sometimes accompanied by share buybacks, dividend boosts, and other "good things for investors." However, Litman says, "None of these can be as good for shareholders as massive growth into an incrementally high return business."

If a company you own is transitioning to this stage, you may want to consider that its high-return days are behind it.

The next Home Depot
The natural question, then, is which companies today are exhibiting characteristics similar to Home Depot in the early part of its high-growth, negative-cash-flow phase?

I set up a screen for all companies on U.S. exchanges with a market cap greater than $200 million that:

  • Have grown their revenues an average of 25% or more over the past two years.
  • Have grown their capital expenditures an average of 25% or more over the past two years.
  • Have generated negative free cash flow each of the past two years.

Because we're looking for younger businesses early in their growth cycles, I also limited the results to companies that were founded since 2000. Just 23 pass the screen:

Company

Market Cap
(millions)

Industry

3-Year Revenue Growth (CAGR)

3-Year CapEx Growth (CAGR)

FCF (TTM)

Tesla Motors

$3,072

Automobile manufacturers

37%

385%

($282)

Allied Nevada Gold

$2,715

Gold

133%

198%

($43)

Oasis Petroleum

$2,663

Oil and gas exploration and production

109%

109%

($377)

Molycorp (NYSE: MCP  )

$2,389

Diversified metals and mining

388%

724%

($160)

Energy XXI (Bermuda)

$2,247

Oil and gas exploration and production

58%

155%

($857)

Opko Health (NYSE: OPK  )

$1,390

Biotechnology

134%

193%

($15)

Legacy Reserves

$1,251

Oil and gas exploration and production

57%

84%

($108)

MAKO Surgical (Nasdaq: MAKO  )

$1,069

Healthcare equipment

59%

42%

($33)

Approach Resources

$960

Oil and gas exploration and production

47%

133%

($173)

Insulet

$874

Healthcare equipment

52%

114%

($37)

Seaspan (NYSE: SSW  )

$843

Marine

40%

28%

($511)

Vanguard Natural Resources

$814

Oil and gas exploration and production

141%

90%

($62)

Rex Energy

$627

Oil and gas exploration and production

48%

77%

($177)

Zipcar

$520

Motor vehicle rental

33%

224%

($34)

Amyris

$515

Oil and gas refining and marketing

129%

57%

($164)

RealD

$468

Electronic equipment and instruments

114%

137%

($52)

Alexco Resource

$416

Precious metals and minerals

242%

36%

($25)

Velti

$390

Internet software and services

91%

34%

($58)

Syneron Medical

$355

Healthcare equipment

101%

61%

($37)

Vantage Drilling (AMEX: VTG  )

$320

Oil and gas drilling

147%

56%

($699)

A123 Systems (Nasdaq: AONE  )

$251

Electrical components and equipment

26%

106%

($423)

Triangle Petroleum

$239

Oil and gas exploration and production

193%

328%

($90)

Rubicon Technology (Nasdaq: RBCN  )

$230

Semiconductor equipment

207%

200%

($11)

Source: S&P Capital IQ.

We're left with a list of young small-cap companies that are investing heavily back into their high-growth business -- just as Home Depot was doing in 1985.

Of the companies listed here, I'm most intrigued by the following four because they seem most true to the early Home Depot profile:

Zipcar -- Fills a huge need with its car-sharing network in major cities. Its losses are narrowing, while cash from operations is positive and growing quickly.

MAKO Surgical -- Makes a robotic surgical system for knee and hip arthroplasty procedures. While cash losses from operations are diminishing, management expects capital expenditures to keep increasing.

A123 Systems -- Makes rechargeable lithium-ion batteries and battery systems for the transportation industry and electric power grids. Management expects continued negative free cash flow for the foreseeable future as it continues to expand manufacturing.

Seaspan -- Operates a fleet of container ships that it charters to large shipping clients on long-term, fixed-rate contracts. It has added 14 ships over the past year or so, and intends to "significantly expand" the fleet in the coming years.

I'll personally be digging deeper into the businesses of these four in the weeks ahead.

Meanwhile, one negative-free-cash flow company that didn't show up on my screen is interesting for another reason: it's well-positioned to take advantage of the natural gas boom. Find out more in our special free report, "One Stock to Own Before Nat Gas Act 2011 Becomes Law."

Fool analyst Rex Moore drives on a parkway and parks on a driveway. He owns no companies mentioned in this article. The Motley Fool owns shares of Seaspan, Amyris, Zipcar, and MAKO Surgical. Motley Fool newsletter services have recommended buying shares of Tesla Motors, MAKO Surgical, and Zipcar, as well as writing a covered straddle position in Seaspan. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (14) | Recommend This Article (47)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 16, 2011, at 6:37 PM, TheDumbMoney wrote:

    Great article, deserves more recs and prominence. A lot of value guys like me start out focused on Graham numbers, then we do discounted cash flows, etc., and get stuck on that. I know I have, and still do. Then one day you're like, what is up with super-fast growing companies that have low free cash flow and incredible sustainable returns? (AMZN for years was a great exemplar, and probably still is.) That's the day one decides Rick Munnariz isn't the crazy lunatic one previously thought he was, and the day one goes and reads Phillip Fisher.

  • Report this Comment On December 17, 2011, at 1:15 PM, wrenchbender57 wrote:

    Since 2001 HD stock lost approximately 10% of it's value according the the second chart shown. So, why is this a good thing? I would not want to own a stock that lost that much value. Unless it paid great dividends or some other reason to own it. HD stock looks like a loser from 2001 to now. What am I missing? Thanks

  • Report this Comment On December 17, 2011, at 1:23 PM, mikecart1 wrote:

    Pretty much any household known company today that was around 20 years ago would have 'crushed' the market. Many of these articles just pick out trends of companies that generally went up during the 90s before the market bubble. I would rather see more articles on the future. Not of companies that crushed the market and then try to find a thesis of why they did or how they did despite not following some 'rule' or 'characteristic' of a good company/stock.

  • Report this Comment On December 17, 2011, at 3:34 PM, AAAMPblog wrote:

    Your ariticle is right on! I prefer to use free cash flow. Net Cash Flow tells you how much cash a company is generating from operations. That is the first important metric. How they distribute that cash flow (dividends, lower debt, or reinvest for growth) is a seperate question. I have written an article showing how relating cash flow to enterprise value is possibly the best stock valuation calculation to value a company.

    http://blog.arborinvestmentplanner.com/2011/05/best-stock-va...

  • Report this Comment On December 17, 2011, at 4:59 PM, dsciola wrote:

    Good article about the merits of a company with negative FCF, I myself use those metric primarily for valuation, yet need to realize its not perfect.

    A real key point here IMO though is determining if the CapEx the company is spending is actually cash well spent. You can't just blindly assume mgmt knows what its doing with that cash coming in. I'de love to hear more about how Litman determines a company's CapEx may "realize returns above the cost of that capital," and thus be an indicator of a good neg FCF business and a worthwhile investment.

    Case in point AONE trades at $1.65 right now and 3 yrs ago was nearly at $25. Something tells me they weren't exactly spending that cash well and realizing a return above their CapEx spending. Either way, I am eager to hear more about your analysis of them and your other 3 picks over the next few weeks.

    Dom

  • Report this Comment On December 17, 2011, at 6:34 PM, Synchronism wrote:

    Rex,

    You've got a great article here. While I didn't really learn much from it as far as the "analytical approach" goes, your writing blew me away in the form of the sample case you provided through Home Depot...... and in the screening. Great to have new targets to aim my gun at, if you know what I mean. ;)

    What you wrote reminds for investors to focus on the business and its economics going forward rather than obsessing solely over FS-derived numbers and ratios.

    This brings to mind several questions, some of which Dom already hinted on:

    1. How much of CAPEX was translated from outflows into inflows, i.e. did it help the company?

    2. Does current research on industry prospects support growth catalysts in the medium term? Will they continue its historical growth rate or propel it to new heights?

    3. Given these potential events, is the current price attractive now, or is there any macro indicators that imply a chance of getting it at an even better one?

    4. Is OCF supported by the business? Or does it lean on working capital and unusual adjustments to income?

    5. Can you trust the OCF value in the first place?

    At any rate, I'll be looking forward to your analysis and valuation of Zipcar and MAKO surgical. ^^

  • Report this Comment On December 17, 2011, at 8:11 PM, TMFOrangeblood wrote:

    @wrenchbender57, the second chart points out how poorly Home Depot performed once the market saw the rate of reinvestment back into its business slow dramatically. As I said, "If a company you own is transitioning to this stage, you may want to consider that its high-return days are behind it."

    -Rex

  • Report this Comment On December 17, 2011, at 8:17 PM, TMFOrangeblood wrote:

    @mikecart1, you say "Pretty much any household known company today that was around 20 years ago would have 'crushed' the market."

    HD gained 1,500% during that time... it was one of the top performers in an era where tech and Internet stocks ruled.

    You also say "I would rather see more articles on the future."

    That's what the screen is for. The whole point of the article is to find companies that may also do well that the market is overlooking.

  • Report this Comment On December 17, 2011, at 8:20 PM, TMFOrangeblood wrote:

    @dsciola and @Synchronism, thanks for the comments! These are all points I intend to address in my follow-up articles.

    -Rex

  • Report this Comment On December 18, 2011, at 2:14 PM, dctodd27 wrote:

    I have a hard time getting on board this train of thought. Yes, HD ended up being a very profitable company despite years of negative FCF, but I have to believe they are the exception by far. James Montier put it best when he talked about setting up a business that sells $20 bills for $19 each. Your sales/revenue will be through the roof but you'll never be profitable. It's easy to cherry pick the success stories from 20 years ago, however the fact remains that most unprofitable companies eventually go out of business - its as simple as that. I'd rather buy unloved companies that can actually turn a profit than try and guess which cash-burner will be the 1-in-a-thousand that actually makes it.

  • Report this Comment On December 18, 2011, at 10:36 PM, TMFOrangeblood wrote:

    @dctodd27, the issue is not a matter of buying into a company that's not profitable and never will be. HD could have turned off the expansion at any time and been very profitable, but doing so would have neutered the size of its future profits. This is something to contemplate with any business we evaluate in this manner.

  • Report this Comment On December 19, 2011, at 1:33 PM, Synchronism wrote:

    @ dctodd27

    Profitability is in the eye of the beholder.

    What matters more is how the numbers reflect the qualitative aspect of the company.

    If you screen out companies just because they have consistently high negative FCF, you **will** miss out on opportunities. I've already failed to make 50% in two companies (within two separate 5-month periods) because of this.

    Tell me. What would you think if you saw a company that:

    1. Posted consistently high OCF before changes in working capital enter the play?

    2. For the past ten years, had CAPEX equivalent to at least 2x the value of OCF, before or after working capital?

    3. Was guaranteed zero competition and currently had a less-than-maximized level of market penetration?

    4. Pursued overseas projects with high potential to affect revenues, but the market has yet to price it in?

    This is a real company by the way. Not a hypothetical one. :)

  • Report this Comment On December 20, 2011, at 2:31 AM, strelna wrote:

    Thank you very much. I have been asking questions on boards recently and found this article extremely helpful.

    It seems to me that the presence of FCF is nice to see (though as you have shown, not necessarily). If FCF is nice to see, then ratios need to be added to test continued high return on capital employed.

    If FCF exists, while, say, ROIC is high and FCF/sales% is high, could this be the best of all worlds?

  • Report this Comment On December 22, 2011, at 1:13 PM, Synchronism wrote:

    ^ could be. But I would be suspicious.

    1. On ROIC: first, it depends on your denominator. Second, what matters is the gap between that and the cost of capital. Third, you have to see if the qualitative factors support a continuation of this gap going forward.

    2. On FCF/Sales: you've got to consider the consistency between OCF and Income, followed by the impact of CAPEX on FCF.

    3. OCF itself! Even the way it is computed is important. You can't put full trust on anything from the financial statements -- for all you know they could've hidden some crucial OCF figure somewhere OR the computation includes numbers that are too large in magnitude to be reliable looking ahead.

    You want to be as confident as possible with your investment and to attain that level of confidence you need to be thorough.

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